Environmental, social and governance (ESG) investing is a hot topic as institutions race to integrate ESG processes and transform conversations into concrete actions. But while the growth of institutional investors’ ESG assets has accelerated in the past 18 months, retail ESG investment solutions account for only a fraction of the wider market. Could exchange-traded funds (ETFs) be the key to unlocking ESG for retail investors and consumers? James McManus, investment manager and head of ETF research at Nutmeg investigates.
For institutional investors, ESG considerations are becoming as core to their investment strategy as valuation and risk. Membership of the Principles for Responsible Investment, an international investor signatory group, has grown by over 30% since 2006, with signatories managing a combined $82 trillion1 as of April 2018.
But ESG remains a relatively new concept among retail investors and is often viewed with some scepticism. Asset managers globally face a battle on a number of fronts – the integration of ESG into their investment processes, the need to develop more ESG-focused investment solutions, and the need to convince retail investors that this isn’t just another sales pitch.
However, it is ETFs that could provide a solution here, thanks to a unique combination of factors.
Rather than being a blunt instrument, an index-based approach to ESG actually maximises the opportunity set in an efficient way.
ESG indices incorporate ratings that are created through the synthesis of vast quantities of qualitative and quantitative data, from a wide range of sources. That means the average investor benefits from research resources typically beyond their individual means.
Admittedly, it is quality as well as quantity that matters in any ESG dataset, yet the fact remains that index products use institutional quality tools to offer exceptional value for money for investors.
"We believe investors need pragmatic, focused and consistent ESG investment solutions that contribute to the conversation around ESG investing, deliver clear outcomes, and meet a wide range of objectives and suitability frameworks."
In addition, and contrary to some assertions, we find that ETF managers are typically highly engaged when it comes to their corporate governance and stewardship. They are true long-term holders of securities, for whom liquidating positions in a given security is not a realistic option.
But a fact often forgotten is that many of the world’s largest ETF issuers also have significant active management businesses allowing them to leverage significant governance resources, at minimal cost.
Index approaches provide clear and consistent methodologies for inclusions and exclusion of securities. Investors may not always agree with the methodology employed, in terms of the screens used or the industries or securities selected, but the application of the methodology is systematic and transparent – something that is not guaranteed in other ESG mandates.
Consistency matters when building investment solutions for the retail market, because investors require total portfolio solutions, not just standalone strategies. Diversification is a key route to risk mitigation, and this most often involves a multi-asset approach.
"Investors that are interested in ESG themes are typically more engaged in their investments than other investors."
Single asset class ESG strategies have often been built with individual philosophies and without an eye to how they fit within a wider portfolio context. As a standalone strategy they make sense, but combined with other assets they display contrasting or conflicting approaches.
It quickly becomes difficult for retail investors to keep track of the various ESG philosophies being implemented across their portfolio. Rules based methodologies help create consistency across markets and asset classes.
Transparency is a core feature of ETFs and index investing and a significant advantage when it comes to ESG. While the consistent nature of index methodologies gives investors confidence in building portfolio solutions that stay true to their overall aims, the transparency offered by index products provides comfort that these aims are being achieved.
Investors that are interested in ESG themes are typically more engaged in their investments than other investors. These topics can often be emotion or passion driven because they are based on personal beliefs. We spent over 12 months working with our clients on product design before launching our own ESG proposition to ensure we met expectations and delivered a world class user experience.
One of the key outcomes of this work was how apparent the client need was for concrete outcomes when it comes to ESG investment solutions. It is critically important for investors to have clarity over what they own in their portfolio, why, and what difference it makes that they have chosen an ESG solution over a non-ESG one.
Our clients pointed to the transparency they are given in other aspects of their lives and questioned why this shouldn’t be the case with their investments.
For example, consumers can see how their choices align to their values if they drive a hybrid car instead of a diesel one, choose a household appliance with good energy ratings, or pick an energy supplier that uses renewable sources.
Transparent, rules-based methodologies allow a greater understanding of what is promised, while holdings-based transparency allowed us to create a user experience that provided ESG metrics in real time.
Not only does this provide for evidence of outcomes, it also helps educate and empower investors and encourage wider discussion on key ESG topics.
Too few retail investors understand the difference that they can make through their investments. And too few ESG investment solutions are suitable for mass market audiences.
ESG remains a relatively niche investment area in the wealth industry, and some of the impact investing and sustainability products offered to retail investors are unsuitable for many, either due to structure or risk profile.
We believe investors need pragmatic, focused and consistent ESG investment solutions that contribute to the conversation around ESG investing, deliver clear outcomes, and meet a wide range of objectives and suitability frameworks. And we continue to believe that ETFs are at the forefront of that conversation.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.